UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2013

or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number: 000-26481

(Exact name of registrant as specified in its charter)

NEW YORK	16-0816610
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
220 LIBERTY STREET, WARSAW, NEW YORK	14569
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (585) 786-1100

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the regsitrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer	¨	Accelerated filer	x
Non-accelerated filer	¨  (Do not check if a smaller company)	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The registrant had 13,808,890 shares of Common Stock, $0.01 par value, outstanding as of July 31, 2013.

FINANCIAL INSTITUTIONS, INC.

Form 10-Q

For the Quarterly Period Ended June 30, 2013

TABLE OF CONTENTS

		PAGE
PART I.	FINANCIAL INFORMATION
ITEM 1.	Financial Statements
	Consolidated Statements of Financial Condition— at June 30, 2013 (Unaudited) and December 31, 2012		3
	Consolidated Statements of Income (Unaudited)— Three and six months ended June 30, 2013 and 2012		4
	Consolidated Statements of Comprehensive (Loss) Income (Unaudited)— Three and six months ended June 30, 2013 and 2012		5
	Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)— Six months ended June 30, 2013 and 2012		6
	Consolidated Statements of Cash Flows (Unaudited)— Six months ended June 30, 2013 and 2012		7
	Notes to Consolidated Financial Statements (Unaudited)		8
ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		29
ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk		47
ITEM 4.	Controls and Procedures		47
PART II.	OTHER INFORMATION
ITEM 1.	Legal Proceedings		48
ITEM 1A.	Risk Factors		48
ITEM 6.	Exhibits		48
	Signatures		49

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PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Financial Condition

	June 30,			December 31,
	2013			2012
(Dollars in thousands, except share and per share data)	(Unaudited)
ASSETS
Cash and cash equivalents:
Cash and due from banks	$	50,833		$	60,342
Federal funds sold and interest-bearing deposits in other banks		94			94
Total cash and cash equivalents		50,927			60,436
Securities available for sale, at fair value		810,549			823,796
Securities held to maturity, at amortized cost (fair value of $17,821 and $18,478, respectively)		17,348			17,905
Loans held for sale		3,423			1,518
Loans (net of allowance for loan losses of $25,590 and $24,714, respectively)		1,717,824			1,681,012
Company owned life insurance		48,273			47,386
Premises and equipment, net		36,899			36,618
Goodwill and other intangible assets, net		50,190			50,389
Other assets		46,870			44,805
Total assets	$	2,782,303		$	2,763,865
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing demand	$	511,802		$	501,514
Interest-bearing demand		475,448			449,744
Savings and money market		713,459			655,598
Time deposits		623,527			654,938
Total deposits		2,324,236			2,261,794
Short-term borrowings		193,413			179,806
Other liabilities		19,766			68,368
Total liabilities		2,537,415			2,509,968
Shareholders’ equity:
Series A 3% preferred stock, $100 par value; 1,533 shares authorized and 1,499 shares issued		150			150
Series B-1 8.48% preferred stock, $100 par value, 200,000 shares authorized, 172,445 and 173,210 shares issued, respectively		17,244			17,321
Total preferred equity		17,394			17,471
Common stock, $0.01 par value, 50,000,000 shares authorized and 14,161,597 shares issued		142			142
Additional paid-in capital		67,480			67,710
Retained earnings		179,564			172,244
Accumulated other comprehensive (loss) income		(13,134	)		3,253
Treasury stock, at cost – 353,207 and 373,888 shares, respectively		(6,558	)		(6,923	)
Total shareholders’ equity		244,888			253,897
Total liabilities and shareholders’ equity	$	2,782,303		$	2,763,865

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Income (Unaudited)

	Three months ended				Six months ended
	June 30,				June 30,
(In thousands, except per share amounts)	2013		2012		2013		2012
Interest income:
Interest and fees on loans	$	20,064	$	19,512	$	40,443	$	39,048
Interest and dividends on investment securities		4,278		4,219		8,647		8,133
Total interest income		24,342		23,731		49,090		47,181
Interest expense:
Deposits		1,665		2,169		3,336		4,567
Short-term borrowings		153		174		343		285
Total interest expense		1,818		2,343		3,679		4,852
Net interest income		22,524		21,388		45,411		42,329
Provision for loan losses		1,193		1,459		3,902		2,844
Net interest income after provision for loan losses		21,331		19,929		41,509		39,485
Noninterest income:
Service charges on deposits		2,568		1,974		4,709		3,809
ATM and debit card		1,317		1,072		2,566		2,149
Broker-dealer fees and commissions		650		434		1,349		1,021
Company owned life insurance		438		441		853		867
Net gain on disposal of investment securities		332		1,237		1,224		1,568
Loan servicing		152		409		225		503
Net gain on sale of loans held for sale		35		325		235		658
Impairment charges on investment securities		—		—		—		(91	)
Net gain on disposal of other assets		38		29		39		35
Other		846		769		1,729		1,622
Total noninterest income		6,376		6,690		12,929		12,141
Noninterest expense:
Salaries and employee benefits		9,226		9,071		18,935		18,127
Occupancy and equipment		3,035		2,715		6,204		5,485
Professional services		1,093		1,080		2,030		1,791
Computer and data processing		812		886		1,516		1,486
Supplies and postage		608		573		1,288		1,031
FDIC assessments		364		304		725		601
Advertising and promotions		253		137		467		238
Other		2,071		1,815		3,881		3,479
Total noninterest expense		17,462		16,581		35,046		32,238
Income before income taxes		10,245		10,038		19,392		19,388
Income tax expense		3,395		3,382		6,393		6,536
Net income	$	6,850	$	6,656	$	12,999	$	12,852
Preferred stock dividends		367		368		735		737
Net income available to common shareholders	$	6,483	$	6,288	$	12,264	$	12,115
Earnings per common share (Note 3):
Basic	$	0.47	$	0.46	$	0.89	$	0.89
Diluted	$	0.47	$	0.46	$	0.89	$	0.88
Cash dividends declared per common share	$	0.18	$	0.14	$	0.36	$	0.27
Weighted average common shares outstanding:
Basic		13,739		13,697		13,728		13,686
Diluted		13,767		13,750		13,767		13,742

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive (Loss) Income (Unaudited)

	Three months ended					Six months ended
	June 30,					June 30,
(Dollars in thousands)	2013			2012		2013			2012
Net income	$	6,850		$	6,656	$	12,999		$	12,852
Other comprehensive (loss) income, net of tax:
Net unrealized (losses) gains on investment securities		(14,470	)		2,171		(16,785	)		917
Pension and post-retirement obligations		199			203		398			405
Total other comprehensive (loss) income		(14,271	)		2,374		(16,387	)		1,322
Comprehensive (loss) income	$	(7,421	)	$	9,030	$	(3,388	)	$	14,174

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

Six months ended June 30, 2013 and 2012

(Dollars in thousands, except per share data)	Preferred Equity			Common Stock		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Total Shareholders’ Equity
Balance at January 1, 2012	$	17,473		$	142	$	67,247		$	158,079		$	945		$	(6,692	)	$	237,194
Comprehensive income:
Net income		—			—		—			12,852			—			—			12,852
Other comprehensive loss, net of tax		—			—		—			—			1,322			—			1,322
Total comprehensive income																			14,174
Purchases of common stock for treasury		—			—		—			—			—			(525	)		(525	)
Share-based compensation plans:
Share-based compensation		—			—		318			—			—			—			318
Stock options exercised		—			—		(5	)		—			—			31			26
Restricted stock awards issued, net		—			—		(599	)		—			—			599			—
Excess tax benefit on share-based compensation		—			—		97			—			—			—			97
Directors’ retainer							(10	)								107			97
Cash dividends declared:
Series A 3% Preferred-$1.50 per share		—			—		—			(2	)		—			—			(2	)
Series B-1 8.48% Preferred-$4.24 per share		—			—		—			(735	)		—			—			(735	)
Common-$0.27 per share		—			—		—			(3,698	)		—			—			(3,698	)
Balance at June 30, 2012	$	17,473		$	142	$	67,048		$	166,496		$	2,267		$	(6,480	)	$	246,946
Balance at January 1, 2013	$	17,471		$	142	$	67,710		$	172,244		$	3,253		$	(6,923	)	$	253,897
Comprehensive loss:
Net income		—			—		—			12,999			—			—			12,999
Other comprehensive loss, net of tax		—			—		—			—			(16,387	)		—			(16,387	)
Total comprehensive loss																			(3,388	)
Purchases of common stock for treasury		—			—		—			—			—			(229	)		(229	)
Repurchase of Series B-1 8.48% preferred stock		(77	)		—		(2	)		—			—			—			(79	)
Share-based compensation plans:
Share-based compensation		—			—		205			—			—			—			205
Stock options exercised		—			—		(3	)		—			—			62			59
Restricted stock awards issued, net		—			—		(427	)		—			—			427			—
Excess tax benefit on share-based compensation		—			—		(10	)		—			—			—			(10	)
Directors’ retainer							7									105			112
Cash dividends declared:
Series A 3% Preferred-$1.50 per share		—			—		—			(2	)		—			—			(2	)
Series B-1 8.48% Preferred-$4.24 per share		—			—		—			(733	)		—			—			(733	)
Common-$0.36 per share		—			—		—			(4,944	)		—			—			(4,944	)
Balance at June 30, 2013	$	17,394		$	142	$	67,480		$	179,564		$	(13,134	)	$	(6,558	)	$	244,888

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Unaudited)

	Six months ended
	June 30,
(Dollars in thousands)	2013			2012
Cash flows from operating activities:
Net income	$	12,999		$	12,852
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,099			1,758
Net amortization of premiums on securities		2,560			2,603
Provision for loan losses		3,902			2,844
Share-based compensation		205			318
Deferred income tax expense		2,771			2,591
Proceeds from sale of loans held for sale		19,379			30,528
Originations of loans held for sale		(21,049	)		(29,142	)
Increase in company owned life insurance		(853	)		(867	)
Net gain on sale of loans held for sale		(235	)		(658	)
Net gain on disposal of investment securities		(1,224	)		(1,568	)
Impairment charges on investment securities		—			91
Net gain on sale and disposal of other assets		(39	)		(35	)
Decrease (increase) in other assets		6,562			(1,802	)
(Decrease) increase in other liabilities		(511	)		8,675
Net cash provided by operating activities		26,566			28,188
Cash flows from investing activities:
Purchases of investment securities:
Available for sale		(160,140	)		(223,454	)
Held to maturity		(5,166	)		(6,847	)
Proceeds from principal payments, maturities and calls on investment securities:
Available for sale		94,956			98,123
Held to maturity		5,723			8,421
Proceeds from sales of securities available for sale		1,327			1,670
Net loan originations		(41,340	)		(83,300	)
Purchases of company owned life insurance		(34	)		(34	)
Proceeds from sales of other assets		467			452
Purchases of premises and equipment		(2,258	)		(2,135	)
Net cash received in branch acquisition		—			63,577
Net cash used in investing activities		(106,465	)		(143,527	)
Cash flows from financing activities:
Net increase in deposits		62,442			74,137
Net increase in short-term borrowings		13,607			50,126
Repurchase of preferred stock		(79	)		—
Purchase of common stock for treasury		(229	)		(525	)
Proceeds from stock options exercised		59			26
Excess tax benefit on share-based compensation, net		(10	)		97
Cash dividends paid to preferred shareholders		(736	)		(737	)
Cash dividends paid to common shareholders		(4,664	)		(3,555	)
Net cash provided by financing activities		70,390			119,569
Net (decrease) increase in cash and cash equivalents		(9,509	)		4,230
Cash and cash equivalents, beginning of period		60,436			57,583
Cash and cash equivalents, end of period	$	50,927		$	61,813
Supplemental information
Cash paid for interest	$	3,679		$	5,409
Cash paid for income taxes		1,697			3,302
Noncash investing and financing activities:
Real estate and other assets acquired in settlement of loans		626			183
Accrued and declared unpaid dividends		2,841			2,287
(Decrease) increase in net unsettled security purchases		(47,972	)		13,938
Assets acquired and liabilities assumed in branch acquisition:
Loans and other non-cash assets, excluding goodwill and core deposit intangible asset		—			59,966
Deposits and other liabilities		—			130,032

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.) BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

Financial Institutions, Inc., a financial holding company organized under the laws of New York State (“New York” or “NYS”), and its subsidiaries provide deposit, lending and other financial services to individuals and businesses in Central and Western New York. The Company has also expanded its indirect lending network to include relationships with franchised automobile dealers in the Capital District of New York and Northern Pennsylvania. Financial Institutions, Inc. owns all of the capital stock of Five Star Bank, a New York State chartered bank, and Five Star Investment Services, Inc., a financial services subsidiary offering noninsured investment products and investment advisory services. References to “the Company” mean the consolidated reporting entities and references to “the Bank” mean Five Star Bank.

Basis of Presentation

The consolidated financial statements include the accounts of Financial Institutions, Inc. and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting policies conform to U.S. generally accepted accounting principles (“GAAP”). Certain information and footnote disclosures normally included in financial statements prepared in conformity with GAAP have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying consolidated financial statements reflect all adjustments of a normal and recurring nature necessary for a fair presentation of the consolidated statements of financial condition, income, comprehensive income, changes in shareholders’ equity and cash flows for the periods indicated, and contain adequate disclosure to make the information presented not misleading. Prior years’ consolidated financial statements are re-classified whenever necessary to conform to the current year’s presentation. These consolidated financial statements should be read in conjunction with the Company’s 2012 Annual Report on Form 10-K. The results of operations for any interim periods are not necessarily indicative of the results which may be expected for the entire year.

Subsequent Events

The Company has evaluated events and transactions for potential recognition or disclosure through the day the financial statements were issued.

Use of Estimates

The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates relate to the determination of the allowance for loan losses, assumptions used in the defined benefit pension plan accounting, the carrying value of goodwill and deferred tax assets, and the valuation and other than temporary impairment considerations related to the securities portfolio.

Reclassifications

Certain reclassifications have been made to the prior years’ financial statements in order to reflect retrospective adjustments made to the balance of goodwill at December 31, 2012 to reflect the effect of these measurement period adjustments made in accordance with accounting requirements. The reclassifications had no impact on shareholders’ equity or net income.

Recent Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. ASU No. 2013-02 does not amend any existing requirements for reporting net income or other comprehensive income in the financial statements. ASU No. 2013-02 requires an entity to disaggregate the total change of each component of other comprehensive income (e.g., unrealized gains or losses on available-for-sale investment securities) and separately present reclassification adjustments and current period other comprehensive income. The provisions of ASU No. 2013-02 also requires that entities present either in a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source (e.g., unrealized gains or losses on available-for-sale investment securities) and the income statement line item affected by the reclassification (e.g., realized gains (losses) on sales of investment securities). If a component is not required to be reclassified to net income in its entirety (e.g., amortization of defined benefit plan items), entities would instead cross reference to the related note to the financial statements for additional information (e.g., pension footnote). The Company adopted the provisions of ASU No. 2013-02 effective January 1, 2013. As the Company provided these required disclosures in the notes to the consolidated financial statements, the adoption of ASU No. 2013-02 had no impact on the Company’s consolidated statements of income and condition. See Note 8 – Accumulated Other Comprehensive Income to the consolidated financial statements for the disclosures required by ASU No. 2013-02.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(2.) BRANCH ACQUISITIONS

On January 19, 2012, the Bank entered into agreements with First Niagara Bank, National Association (“First Niagara”) to acquire four retail bank branches in Medina, Brockport, Batavia and Waterloo, New York (the “First Niagara Branches”) and four retail bank branches previously owned by HSBC Bank USA, National Association (“HSBC”) in Elmira, Elmira Heights, Horseheads and Albion, New York (the “HSBC Branches”). First Niagara assigned its rights to the HSBC branches in connection with its acquisition of HSBC’s Upstate New York banking franchise. Under the terms of the agreements, the Bank assumed substantially all related deposits and purchased the related branch premises and certain performing loans. The transaction to acquire the First Niagara Branches was completed on June 22, 2012 and the transaction to acquire the HSBC Branches was completed on August 17, 2012. The combined assets acquired and deposits assumed in the two transactions were recorded at their estimated fair values as follows (in thousands):

Cash	$	195,778
Loans		75,635
Bank premises and equipment		1,938
Goodwill		11,167
Core deposit intangible asset		2,042
Other assets		601
Total assets acquired	$	287,161
Deposits assumed	$	286,819
Other liabilities		342
Total liabilities assumed	$	287,161

The transactions were accounted for using the acquisition method of accounting and accordingly, assets acquired, liabilities assumed and consideration exchanged were recorded at their estimated fair values on the acquisition dates. Fair values are preliminary and in certain cases are subject to refinement for up to one year after the closing date of the acquisition as additional information relative to fair values becomes available. During the three months ended March 31, 2013, the Company recorded a decrease to the estimated fair value of liabilities assumed and an increase to the related deferred income taxes based upon information obtained subsequent to the acquisition. In addition to changes in those assets and liabilities, the revisions resulted in a reduction in goodwill approximating $432 thousand.

The Company acquired the loan portfolios at a fair value discount of $824 thousand. The discount represents expected credit losses, net of market interest rate adjustments. The discount on loans receivable will be amortized to interest income over the estimated remaining life of the acquired loans using the level yield method. The time deposit premium of $335 thousand will be accreted over the estimated remaining life of the related deposits as a reduction of interest expense. The core deposit intangible asset will be amortized on an accelerated basis over the estimated average life of the core deposits.

All goodwill and core deposit intangible assets arising from this acquisition are expected to be deductible for tax purposes.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(3.) EARNINGS PER COMMON SHARE (“EPS”)

The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS (in thousands, except per share amounts).

	Three months ended June 30,						Six months ended June 30,
	2013			2012			2013			2012
Net income available to common shareholders	$	6,483		$	6,288		$	12,264		$	12,115
Less: Earnings allocated to participating securities		—			—			—			3
Net income available to common shareholders for EPS	$	6,483		$	6,288		$	12,264		$	12,112
Weighted average common shares outstanding:
Total shares issued		14,162			14,162			14,162			14,162
Unvested restricted stock awards		(66	)		(123	)		(73	)		(125	)
Treasury shares		(357	)		(342	)		(361	)		(351	)
Total basic weighted average common shares outstanding		13,739			13,697			13,728			13,686
Incremental shares from assumed:
Exercise of stock options		5			3			6			3
Vesting of restricted stock awards		23			50			33			53
Total diluted weighted average common shares outstanding		13,767			13,750			13,767			13,742
Basic earnings per common share	$	0.47		$	0.46		$	0.89		$	0.89
Diluted earnings per common share	$	0.47		$	0.46		$	0.89		$	0.88
For each of the periods presented, average shares subject to the following instruments were excluded from the computation of diluted EPS because the effect would be antidilutive:
Stock options		225			307			188			317
Restricted stock awards		9			2			5			1
		234			309			193			318

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(4.) INVESTMENT SECURITIES

The amortized cost and fair value of investment securities are summarized below (in thousands):

	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
June 30, 2013
Securities available for sale:
U.S. Government agencies and government sponsored enterprises	$	113,683	$	1,638	$	2,382	$	112,939
State and political subdivisions		222,726		2,853		2,873		222,706
Mortgage-backed securities:
Federal National Mortgage Association		156,614		1,648		5,295		152,967
Federal Home Loan Mortgage Corporation		36,980		670		70		37,580
Government National Mortgage Association		46,597		2,307		—		48,904
Collateralized mortgage obligations:
Federal National Mortgage Association		70,210		605		1,489		69,326
Federal Home Loan Mortgage Corporation		109,913		357		3,455		106,815
Government National Mortgage Association		55,008		1,522		299		56,231
Privately issued		—		2,604		—		2,604
Total collateralized mortgage obligations		235,131		5,088		5,243		234,976
Total mortgage-backed securities		475,322		9,713		10,608		474,427
Asset-backed securities		18		459		—		477
Total available for sale securities	$	811,749	$	14,663	$	15,863	$	810,549
Securities held to maturity:
State and political subdivisions	$	17,348	$	473	$	—	$	17,821
December 31, 2012
Securities available for sale:
U.S. Government agencies and government sponsored enterprises	$	128,097	$	3,667	$	69	$	131,695
State and political subdivisions		188,997		6,285		72		195,210
Mortgage-backed securities:
Federal National Mortgage Association		147,946		4,394		188		152,152
Federal Home Loan Mortgage Corporation		65,426		1,430		—		66,856
Government National Mortgage Association		56,166		3,279		—		59,445
Collateralized mortgage obligations:
Federal National Mortgage Association		60,805		1,865		2		62,668
Federal Home Loan Mortgage Corporation		78,581		1,911		—		80,492
Government National Mortgage Association		70,989		2,168		—		73,157
Privately issued		73		1,025		—		1,098
Total collateralized mortgage obligations		210,448		6,969		2		217,415
Total mortgage-backed securities		479,986		16,072		190		495,868
Asset-backed securities		121		902		—		1,023
Total available for sale securities	$	797,201	$	26,926	$	331	$	823,796
Securities held to maturity:
State and political subdivisions	$	17,905	$	573	$	—	$	18,478

Sales and calls of securities available for sale were as follows (in thousands):

	Three months ended June  30,				Six months ended June 30,
	2013		2012		2013		2012
Proceeds from sales	$	375	$	1,310	$	1,327	$	1,670
Gross realized gains		332		1,237		1,224		1,568

- 11 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(4.) INVESTMENT SECURITIES (Continued)

The scheduled maturities of securities available for sale and securities held to maturity at June 30, 2013 are shown below (in thousands). Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.

	Amortized		Fair
	Cost		Value
Debt securities available for sale:
Due in one year or less	$	11,277	$	11,455
Due from one to five years		117,978		120,658
Due after five years through ten years		350,860		343,317
Due after ten years		331,634		335,119
	$	811,749	$	810,549
Debt securities held to maturity:
Due in one year or less	$	13,009	$	13,107
Due from one to five years		3,605		3,837
Due after five years through ten years		647		765
Due after ten years		87		112
	$	17,348	$	17,821

There were no unrealized losses in held to maturity securities at June 30, 2013 or December 31, 2012. Unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

	Less than 12 months				12 months or longer				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
June 30, 2013
U.S. Government agencies and government sponsored enterprises	$	61,730	$	2,377	$	2,868	$	5	$	64,598	$	2,382
State and political subdivisions		108,166		2,873		—		—		108,166		2,873
Mortgage-backed securities:
Federal National Mortgage Association		98,712		5,295		—		—		98,712		5,295
Federal Home Loan Mortgage Corporation		4,270		70		—		—		4,270		70
Collateralized mortgage obligations:
Federal National Mortgage Association		52,604		1,488		665		1		53,269		1,489
Federal Home Loan Mortgage Corporation		96,267		3,455		—		—		96,267		3,455
Government National Mortgage Association		6,682		299		—		—		6,682		299
Total collateralized mortgage obligations		155,553		5,242		665		1		156,218		5,243
Total mortgage-backed securities		258,535		10,607		665		1		259,200		10,608
Total temporarily impaired securities	$	428,431	$	15,857	$	3,533	$	6	$	431,964	$	15,863
December 31, 2012
U.S. Government agencies and government sponsored enterprises	$	13,265	$	67	$	2,967	$	2	$	16,232	$	69
State and political subdivisions		8,471		72		—		—		8,471		72
Mortgage-backed securities:
Federal National Mortgage Association		25,200		188		—		—		25,200		188
Collateralized mortgage obligations:
Federal National Mortgage Association		—		—		1,173		2		1,173		2
Total collateralized mortgage obligations		—		—		1,173		2		1,173		2
Total mortgage-backed securities		25,200		188		1,173		2		26,373		190
Total temporarily impaired securities	$	46,936	$	327	$	4,140	$	4	$	51,076	$	331

- 12 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(4.) INVESTMENT SECURITIES (Continued)

The total number of security positions in the investment portfolio in an unrealized loss position at June 30, 2013 was 429 compared to 52 at December 31, 2012. At June 30, 2013, the Company had positions in 5 investment securities with a fair value of $3.5 million and a total unrealized loss of $6 thousand that have been in a continuous unrealized loss position for more than 12 months. There were a total of 424 securities positions in the Company’s investment portfolio, with a fair value of $428.4 million and a total unrealized loss of $15.9 million at June 30, 2013, that have been in a continuous unrealized loss position for less than 12 months. The unrealized loss on these investment securities was predominantly caused by changes in market interest rates subsequent to purchase. The fair value of most of the investment securities in the Company’s portfolio fluctuates as market interest rates change.

The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (“OTTI”) with formal reviews performed quarterly. When evaluating debt securities for OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intention to sell the debt security or whether it is more likely than not that it will be required to sell the debt security before its anticipated recovery. The assessment of whether OTTI exists involves a high degree of subjectivity and judgment and is based on the information then available to management.

No impairment was recorded in the six months ended June 30, 2013. During the six months ended June 30, 2012, the Company recognized an OTTI charge of $91 thousand related to a privately issued whole loan CMO that was determined to be impaired due to credit quality.

Based on management’s review and evaluation of the Company’s debt securities as of June 30, 2013, the debt securities with unrealized losses were not considered to be OTTI. As of June 30, 2013, the Company does not have the intent to sell any of the securities in a loss position and believes that it is not likely that it will be required to sell any such securities before the anticipated recovery of amortized cost. Accordingly, as of June 30, 2013, management has concluded that unrealized losses on its investment securities are temporary and no further impairment loss has been realized in the Company’s consolidated statements of income.

- 13 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) LOANS

The Company’s loan portfolio consisted of the following as of the dates indicated (in thousands):

	Principal Amount Outstanding		Net Deferred Loan (Fees) Costs			Loans, Net
June 30, 2013
Commercial business	$	257,784	$	(52	)	$	257,732
Commercial mortgage		438,513		(998	)		437,515
Residential mortgage		117,939		178			118,117
Home equity		301,429		4,786			306,215
Consumer indirect		572,350		27,236			599,586
Other consumer		24,107		142			24,249
Total	$	1,712,122	$	31,292			1,743,414
Allowance for loan losses							(25,590	)
Total loans, net						$	1,717,824
December 31, 2012
Commercial business	$	258,706	$	(31	)	$	258,675
Commercial mortgage		414,282		(958	)		413,324
Residential mortgage		133,341		179			133,520
Home equity		282,503		4,146			286,649
Consumer indirect		559,964		26,830			586,794
Other consumer		26,657		107			26,764
Total	$	1,675,453	$	30,273			1,705,726
Allowance for loan losses							(24,714	)
Total loans, net						$	1,681,012

Loans held for sale (not included above) were comprised entirely of residential real estate mortgages and totaled $3.4 million and $1.5 million as of June 30, 2013 and December 31, 2012, respectively.

- 14 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) LOANS (Continued)

Past Due Loans Aging

The Company’s recorded investment, by loan class, in current and nonaccrual loans, as well as an analysis of accruing delinquent loans is set forth as of the dates indicated (in thousands):

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Nonaccrual		Current		Total Loans
June 30, 2013
Commercial business	$	170	$	—	$	—	$	170	$	5,043	$	252,571	$	257,784
Commercial mortgage		90		—		—		90		3,073		435,350		438,513
Residential mortgage		791		—		—		791		1,423		115,725		117,939
Home equity		477		30		—		507		699		300,223		301,429
Consumer indirect		1,363		139		—		1,502		1,035		569,813		572,350
Other consumer		134		12		16		162		6		23,939		24,107
Total loans, gross	$	3,025	$	181	$	16	$	3,222	$	11,279	$	1,697,621	$	1,712,122
December 31, 2012
Commercial business	$	160	$	—	$	—	$	160	$	3,413	$	255,133	$	258,706
Commercial mortgage		331		—		—		331		1,799		412,152		414,282
Residential mortgage		376		—		—		376		2,040		130,925		133,341
Home equity		675		10		—		685		939		280,879		282,503
Consumer indirect		1,661		163		—		1,824		891		557,249		559,964
Other consumer		127		35		18		180		25		26,452		26,657
Total loans, gross	$	3,330	$	208	$	18	$	3,556	$	9,107	$	1,662,790	$	1,675,453

There were no loans past due greater than 90 days and still accruing interest as of June 30, 2013 and December 31, 2012. There were $16 thousand and $18 thousand in consumer overdrafts which were past due greater than 90 days as of June 30, 2013 and December 31, 2012, respectively. Consumer overdrafts are overdrawn deposit accounts which have been reclassified as loans but by their terms do not accrue interest.

Troubled Debt Restructurings

A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Company offers various types of concessions when modifying loans, however, forgiveness of principal is rarely granted. Commercial loans modified in a TDR may involve temporary interest-only payments, term extensions, reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, requesting additional collateral, releasing collateral for consideration, or substituting or adding a new borrower or guarantor.

The following table presents information related to loans modified in a TDR during the periods indicated (dollars in thousands).

	Quarter-to-Date						Year-to-Date
	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment		Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment
June 30, 2013
Commercial business		1	$	1,273	$	1,273		3	$	1,462	$	1,453
Commercial mortgage		—		—		—		—		—		—
Total		1	$	1,273	$	1,273		3	$	1,462	$	1,453
June 30, 2012
Commercial business		—	$	—	$	—		2	$	433	$	433
Commercial mortgage		3		602		602		4		648		648
Total		3	$	602	$	602		6	$	1,081	$	1,081

- 15 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) LOANS (Continued)

All of the loans identified as TDRs by the Company were previously on nonaccrual status and reported as impaired loans prior to restructuring. The modifications primarily related to extending the amortization periods of the loans. All loans restructured during the three months ended June 30, 2013 were classified as nonaccrual as of June 30, 2013. Nonaccrual loans that are restructured remain on nonaccrual status, but may move to accrual status after they have performed according to the restructured terms for a period of time. The TDR classification did not have a material impact on the Company’s determination of the allowance for loan losses because the modified loans were impaired and evaluated for a specific reserve both before and after restructuring.

There were no loans modified as a TDR within the previous 12 months that defaulted during the three months ended June 30, 2013 or 2012. For purposes of this disclosure, a loan modified as a TDR is considered to have defaulted when the borrower becomes 90 days past due.

Impaired Loans

Management has determined that specific commercial loans on nonaccrual status and all loans that have had their terms restructured in a troubled debt restructuring are impaired loans. The following table presents the recorded investment, unpaid principal balance and related allowance of impaired loans as of the dates indicated and average recorded investment and interest income recognized on impaired loans for the three month periods ended as of the dates indicated (in thousands):

	Recorded Investment(1)		Unpaid Principal Balance(1)		Related Allowance		Average Recorded Investment		Interest Income Recognized
June 30, 2013
With no related allowance recorded:
Commercial business	$	788	$	1,171	$	—	$	940	$	—
Commercial mortgage		780		835		—		684		—
		1,568		2,006		—		1,624		—
With an allowance recorded:
Commercial business		4,255		4,255		956		4,419		—
Commercial mortgage		2,293		2,293		554		1,936		—
		6,548		6,548		1,510		6,355		—
	$	8,116	$	8,554	$	1,510	$	7,979	$	—
December 31, 2012
With no related allowance recorded:
Commercial business	$	963	$	1,425	$	—	$	755	$	—
Commercial mortgage		911		1,002		—		1,310		—
		1,874		2,427		—		2,065		—
With an allowance recorded:
Commercial business		2,450		2,450		664		2,114		—
Commercial mortgage		888		888		310		1,858		—
		3,338		3,338		974		3,972		—
	$	5,212	$	5,765	$	974	$	6,037	$	—

⁽¹⁾  Difference between recorded investment and unpaid principal balance represents partial charge-offs.

- 16 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) LOANS (Continued)

Credit Quality Indicators

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors such as the fair value of collateral. The Company analyzes commercial business and commercial mortgage loans individually by classifying the loans as to credit risk. Risk ratings are updated any time the situation warrants. The Company uses the following definitions for risk ratings:

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans that do not meet the criteria above that are analyzed individually as part of the process described above are considered “Uncriticized” or pass-rated loans and are included in groups of homogeneous loans with similar risk and loss characteristics.

The following table sets forth the Company’s commercial loan portfolio, categorized by internally assigned asset classification, as of the dates indicated (in thousands):

	Commercial Business		Commercial Mortgage
June 30, 2013
Uncriticized	$	242,218	$	418,395
Special mention		4,209		12,401
Substandard		11,357		7,717
Doubtful		—		—
Total	$	257,784	$	438,513
December 31, 2012
Uncriticized	$	240,291	$	400,576
Special mention		6,591		6,495
Substandard		11,824		7,211
Doubtful		—		—
Total	$	258,706	$	414,282

The Company utilizes payment status as a means of identifying and reporting problem and potential problem retail loans. The Company considers nonaccrual loans and loans past due greater than 90 days and still accruing interest to be non-performing. The following table sets forth the Company’s retail loan portfolio, categorized by payment status, as of the dates indicated (in thousands):

	Residential Mortgage		Home Equity		Consumer Indirect		Other Consumer
June 30, 2013
Performing	$	116,516	$	300,730	$	571,315	$	24,085
Non-performing		1,423		699		1,035		22
Total	$	117,939	$	301,429	$	572,350	$	24,107
December 31, 2012
Performing	$	131,301	$	281,564	$	559,073	$	26,632
Non-performing		2,040		939		891		25
Total	$	133,341	$	282,503	$	559,964	$	26,657

- 17 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) LOANS (Continued)

Allowance for Loan Losses

Loans and the related allowance for loan losses are presented below as of the dates indicated (in thousands):

	Commercial Business		Commercial Mortgage		Residential Mortgage		Home Equity		Consumer Indirect		Other Consumer		Total
June 30, 2013
Loans:
Ending balance	$	257,784	$	438,513	$	117,939	$	301,429	$	572,350	$	24,107	$	1,712,122
Evaluated for impairment:
Individually	$	5,043	$	3,073	$	—	$	—	$	—	$	—	$	8,116
Collectively	$	252,741	$	435,440	$	117,939	$	301,429	$	572,350	$	24,107	$	1,704,006
Allowance for loan losses:
Ending balance	$	4,755	$	7,125	$	701	$	1,424	$	11,095	$	490	$	25,590
Evaluated for impairment:
Individually	$	956	$	554	$	—	$	—	$	—	$	—	$	1,510
Collectively	$	3,799	$	6,571	$	701	$	1,424	$	11,095	$	490	$	24,080
June 30, 2012
Loans:
Ending balance	$	245,513	$	414,766	$	142,635	$	260,855	$	507,598	$	25,172	$	1,596,539
Evaluated for impairment:
Individually	$	4,150	$	3,598	$	—	$	—	$	—	$	—	$	7,748
Collectively	$	241,363	$	411,168	$	142,635	$	260,855	$	507,598	$	25,172	$	1,588,791
Allowance for loan losses:
Ending balance	$	4,364	$	6,713	$	801	$	1,164	$	10,618	$	460	$	24,120
Evaluated for impairment:
Individually	$	863	$	691	$	—	$	—	$	—	$	—	$	1,554
Collectively	$	3,501	$	6,022	$	801	$	1,164	$	10,618	$	460	$	22,566

The following table sets forth the changes in the allowance for loan losses for the three and six month periods ended June 30, 2013 (in thousands):

	Commercial Business			Commercial Mortgage		Residential Mortgage		Home Equity		Consumer Indirect		Other Consumer		Total
Three months ended June 30, 2013
Beginning balance	$	5,167		$	6,971	$	668	$	1,283	$	11,312	$	426	$	25,827
Charge-offs		292			106		85		53		1,929		229		2,694
Recoveries		205			143		13		73		759		71		1,264
Provision (credit)		(325	)		117		105		121		953		222		1,193
Ending balance	$	4,755		$	7,125	$	701	$	1,424	$	11,095	$	490	$	25,590
Six months ended June 30, 2013
Beginning balance	$	4,884		$	6,581	$	740	$	1,282	$	10,715	$	512	$	24,714
Charge-offs		531			109		247		322		3,647		481		5,337
Recoveries		242			157		30		110		1,564		208		2,311
Provision		160			496		178		354		2,463		251		3,902
Ending balance	$	4,755		$	7,125	$	701	$	1,424	$	11,095	$	490	$	25,590

- 18 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) LOANS (Continued)

The following table sets forth the changes in the allowance for loan losses for the three and six month periods ended June 30, 2012 (in thousands):

	Commercial Business			Commercial Mortgage		Residential Mortgage		Home Equity			Consumer Indirect		Other Consumer			Total
Three months ended June 30, 2012
Beginning balance	$	4,386		$	6,788	$	822	$	1,281		$	9,999	$	487		$	23,763
Charge-offs		144			227		127		93			1,407		90			2,088
Recoveries		155			61		28		11			746		(15	)		986
Provision (credit)		(33	)		91		78		(35	)		1,280		78			1,459
Ending balance	$	4,364		$	6,713	$	801	$	1,164		$	10,618	$	460		$	24,120
Six months ended June 30, 2012
Beginning balance	$	4,036		$	6,418	$	858	$	1,242		$	10,189	$	517		$	23,260
Charge-offs		199			347		233		97			2,802		404			4,082
Recoveries		232			76		98		20			1,473		199			2,098
Provision (credit)		295			566		78		(1	)		1,758		148			2,844
Ending balance	$	4,364		$	6,713	$	801	$	1,164		$	10,618	$	460		$	24,120

Risk Characteristics

Commercial business loans primarily consist of loans to small to midsize businesses in our market area in a diverse range of industries. These loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value. The credit risk related to commercial loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.

Commercial mortgage loans generally have larger balances and involve a greater degree of risk than residential mortgage loans, inferring higher potential losses on an individual customer basis. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral securing the loan. Economic events or conditions in the real estate market could have an adverse impact on the cash flows generated by properties securing the Company’s commercial real estate loans and on the value of such properties.

Residential mortgage loans and home equities (comprised of home equity loans and home equity lines) are generally made on the basis of the borrower’s ability to make repayment from his or her employment and other income, but are secured by real property whose value tends to be more easily ascertainable. Credit risk for these types of loans is generally influenced by general economic conditions, the characteristics of individual borrowers, and the nature of the loan collateral.

Consumer indirect and other consumer loans may entail greater credit risk than residential mortgage loans and home equities, particularly in the case of other consumer loans which are unsecured or, in the case of indirect consumer loans, secured by depreciable assets, such as automobiles or boats. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances such as job loss, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

- 19 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.) GOODWILL AND OTHER INTANGIBLE ASSETS

The carrying amount of goodwill totaled $48.5 million as of June 30, 2013 and December 31, 2012. The goodwill relates to the Company’s primary subsidiary and reporting unit, Five Star Bank. The Company performs a goodwill impairment test on an annual basis or more frequently if events and circumstances warrant.

The Company recorded a core deposit intangible asset of $2.0 million in connection with the 2012 branch acquisitions which will be amortized on an accelerated basis over the remaining estimated average life of the core deposits of approximately 8.8 years. The amortization expense is included in other noninterest expense on the consolidated statements of income and is deductible for tax purposes.

Amortization expense for the core deposit intangible was $98 thousand and $199 thousand for the three and six months ended June 30, 2013, respectively. There was no amortization expense for the three and six months ended June 30, 2012. As of June 30, 2013, estimated core deposit intangible amortization expense for each of the next five years is as follows (in thousands):

2013 (remainder of year)	$	187
2014		341
2015		296
2016		251
2017		205

(7.) SHAREHOLDERS’ EQUITY

Common Stock

The changes in shares of common stock were as follows for the six month periods ended June 30, 2013 and 2012:

	Outstanding			Treasury			Issued
June 30, 2013
Shares outstanding at December 31, 2012		13,787,709			373,888			14,161,597
Restricted stock awards issued		42,035			(42,035	)		—
Restricted stock awards forfeited		(18,977	)		18,977			—
Stock options exercised		3,300			(3,300	)		—
Treasury stock purchases		(11,349	)		11,349			—
Directors’ retainer		5,672			(5,672	)		—
Shares outstanding at June 30, 2013		13,808,390			353,207			14,161,597
June 30, 2012
Shares outstanding at December 31, 2011		13,803,116			358,481			14,161,597
Restricted stock awards issued		57,541			(57,541	)		—
Restricted stock awards forfeited		(25,075	)		25,075			—
Stock options exercised		1,650			(1,650	)		—
Treasury stock purchases		(31,518	)		31,518			—
Directors’ retainer		5,816			(5,816	)		—
Shares outstanding at June 30, 2012		13,811,530			350,067			14,161,597

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(8.) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table presents the components of other comprehensive income (loss) for the six month periods ended June 30, 2013 and 2012 (in thousands):

	Pre-tax Amount			Tax Effect			Net-of-tax Amount
June 30, 2013
Net unrealized losses on investment securities:
Net unrealized losses arising during the period	$	(26,571	)	$	(10,525	)	$	(16,046	)
Reclassification adjustment for gains included in income		(1,224	)		(485	)		(739	)
Net unrealized losses on investment securities		(27,795	)		(11,010	)		(16,785	)
Pension and post-retirement obligations:
Amortization of prior service credit		(24	)		(9	)		(15	)
Amortization of actuarial losses		682			269			413
Pension and post-retirement obligations, net		658			260			398
Other comprehensive loss	$	(27,137	)	$	(10,750	)	$	(16,387	)
June 30, 2012
Net unrealized gains on investment securities:
Net unrealized gains arising during the period	$	2,995		$	1,186		$	1,809
Reclassification adjustment for gains included in income		(1,568	)		(621	)		(947	)
Reclassification adjustment for impairment charges included in income		91			36			55
Net unrealized gains on investment securities		1,518			601			917
Pension and post-retirement obligations:
Amortization of prior service credit		(24	)		(9	)		(15	)
Amortization of actuarial losses		695			275			420
Pension and post-retirement obligations, net		671			266			405
Other comprehensive income	$	2,189		$	867		$	1,322

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(8.) ACCUMULATED OTHER COMPREHENSIVE INCOME (Continued)

The following table presents the changes in each component of accumulated other comprehensive income (loss), net of tax, for the six month period ended June 30, 2013 (in thousands):

	Net Unrealized Gains (Losses) on Investment Securities			Pension and Post-retirement Obligations			Total
Balance at beginning of year	$	16,060		$	(12,807	)	$	3,253
Other comprehensive loss before reclassifications		(16,046	)		398			(15,648	)
Amounts reclassified from accumulated other comprehensive income		(739	)		—			(739	)
Net current period other comprehensive loss		(16,785	)		398			(16,387	)
Balance at end of period	$	(725	)	$	(12,409	)	$	(13,134	)

The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (loss) for the six month period ended June 30, 2013 (in thousands):

Details About Accumulated Other Comprehensive Income Components	Amount Reclassified from Accumulated Other Comprehensive Income			Affected Line Item in the Consolidated Statement of Income
Realized gain on sale of investment securities	$	1,224		Net gain on disposal of investment securities
		(485	)	Income tax expense
	$	739		Net of tax
Pension and post-retirement obligations
Amortization of prior service benefit (1)	$	24		Salaries and employee benefits
Amortization of actuarial losses (1)		(682	)	Salaries and employee benefits
		(658	)	Total before tax
		260		Income tax benefit
	$	(398	)	Net of tax

⁽¹⁾  These items are included in the computation of net periodic pension cost. See Note 10 – Employee Benefit Plans for additional information.

(9.) SHARE-BASED COMPENSATION PLANS

The Company maintains certain stock-based compensation plans that were approved by the Company’s shareholders and are administered by the Company’s Board, or the Management Development and Compensation Committee of the Board. The share-based compensation plans were established to allow for the grant of compensation awards to attract, motivate and retain employees, executive officers and non-employee directors who contribute to the success and profitability of the Company and to give such persons a proprietary interest in the Company, thereby enhancing their personal interest in the Company’s success.

The Company awarded grants of 33,035 restricted shares to certain members of management during the six months ended June 30, 2013. Fifty percent of the shares subject to each grant will be earned based upon achievement of an EPS performance requirement for the Company’s fiscal year ended December 31, 2013. The remaining fifty percent of the shares will be earned based on the Company’s achievement of a relative total shareholder return (“TSR”) performance requirement, on a percentile basis, compared to a defined group of peer companies over a three-year performance period ended December 31, 2015. The shares earned based on the achievement of the EPS and TSR performance requirements, if any, will vest based on the recipient’s continuous service to the Company on December 31, 2015.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(9.) SHARE-BASED COMPENSATION PLANS (Continued)

The grant-date fair value of the TSR portion of the award granted during the six month period ended June 30, 2013 was determined using the Monte Carlo simulation model on the date of grant, assuming the following (i) expected term of 2.88 years, (ii) risk free interest rate of 0.42%, (iii) expected dividend yield of 3.59% and (iv) expected stock price volatility over the expected term of the TSR award of 37.2%. The grant-date fair value of all other restricted stock awards is equal to the closing market price of our common stock on the date of grant.

During the six months ended June 30, 2013, the Company granted 9,000 restricted shares of common stock to directors, of which 4,500 shares vested immediately and 4,500 shares will vest after completion of a one-year service requirement. The market price of the restricted stock on the date of grant was $19.81.

The restricted stock awards granted to management and directors in 2013 do not have rights to dividends or dividend equivalents.

The following is a summary of restricted stock award activity for the six month period ended June 30, 2013:

				Weighted
				Average
				Market
	Number of			Price at
	Shares			Grant Date
Outstanding at beginning of year		79,580		$	16.89
Granted		42,035			16.85
Vested		(38,598	)		17.04
Forfeited		(18,977	)		16.60
Outstanding at end of period		64,040		$	16.86

As of June 30, 2013, there was $554 thousand of unrecognized compensation expense related to unvested restricted stock awards that is expected to be recognized over a weighted average period of 1.8 years.

The Company uses the Black-Scholes valuation method to estimate the fair value of its stock option awards. There were no stock options awarded during 2013 or 2012. The following is a summary of stock option activity for the six months ended June 30, 2013 (dollars in thousands, except per share amounts):

						Weighted
				Weighted		Average
				Average		Remaining		Aggregate
	Number of			Exercise		Contractual		Intrinsic
	Options			Price		Term		Value
Outstanding at beginning of year		319,275		$	20.22
Exercised		(3,300	)		17.58
Expired		(43,790	)		21.38
Outstanding and exercisable at end of period		272,185		$	20.07		2.4 years	$	58

As of June 30, 2013, all compensation expense related to stock options had been fully recognized in previous periods.

The aggregate intrinsic value (the amount by which the market price of the stock on the date of exercise exceeded the market price of the stock on the date of grant) of option exercises for the six months ended June 30, 2013 and 2012 was $7 thousand and $2 thousand, respectively. The total cash received as a result of option exercises under stock compensation plans for six months ended June 30, 2013 and 2012 was $59 thousand and $26 thousand, respectively.

The Company amortizes the expense related to restricted stock awards over the vesting period. Share-based compensation expense is recorded as a component of salaries and employee benefits in the consolidated statements of income for awards granted to management and as a component of other noninterest expense for awards granted to directors. The share-based compensation expense included in the consolidated statements of income is as follows (in thousands):

	Three months ended					Six months ended
	June 30,					June 30,
	2013			2012		2013		2012
Salaries and employee benefits	$	(6	)	$	93	$	79	$	220
Other noninterest expense		109			83		126		98
Total share-based compensation expense	$	103		$	176	$	205	$	318

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(10.) EMPLOYEE BENEFIT PLANS

The components of the Company’s net periodic benefit expense for its pension and post-retirement obligations were as follows (in thousands):

	Three months ended						Six months ended
	June 30,						June 30,
	2013			2012			2013			2012
Service cost	$	516		$	509		$	1,032		$	1,018
Interest cost on projected benefit obligation		505			506			1,010			1,011
Expected return on plan assets		(921	)		(803	)		(1,842	)		(1,606	)
Amortization of unrecognized prior service credit		(12	)		(12	)		(24	)		(24	)
Amortization of unrecognized loss		341			347			682			694
Net periodic pension cost	$	429		$	547		$	858		$	1,093

The net periodic benefit expense is recorded as a component of salaries and employee benefits in the consolidated statements of income. The Company’s funding policy is to contribute, at a minimum, an actuarially determined amount that will satisfy the minimum funding requirements determined under the appropriate sections of Internal Revenue Code. The Company has no minimum required contribution for the 2013 fiscal year.

(11.) COMMITMENTS AND CONTINGENCIES

The Company has financial instruments with off-balance sheet risk established in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk extending beyond amounts recognized in the financial statements.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is essentially the same as that involved with extending loans to customers. The Company uses the same credit underwriting policies in making commitments and conditional obligations as for on-balance sheet instruments.

Off-balance sheet commitments consist of the following (in thousands):

	June 30, 2013		December 31, 2012
Commitments to extend credit	$	457,620	$	435,948
Standby letters of credit		9,315		9,223

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments may expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Standby letters of credit are conditional lending commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support private borrowing arrangements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers.

The Company also extends rate lock agreements to borrowers related to the origination of residential mortgage loans. To mitigate the interest rate risk inherent in these rate lock agreements, the Company may enter into forward commitments to sell individual residential mortgages. Rate lock agreements and forward commitments are considered derivatives and are recorded at fair value. The Company had no forward sales commitments at June 30, 2013. Forward sales commitments totaled $1.8 million at December 31, 2012. In addition, the net change in the fair values of these derivatives was recognized as other noninterest income or other noninterest expense in the consolidated statements of income.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(12.) FAIR VALUE MEASUREMENTS

Determination of Fair Value – Assets Measured at Fair Value on a Recurring and Nonrecurring Basis

Valuation Hierarchy

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. There have been no changes in the valuation techniques used during the current period. The fair value hierarchy is as follows:

• Level 1—Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

• Level 2—Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

• Level 3—Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Transfers between levels of the fair value hierarchy are recorded as of the end of the reporting period.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

Securities available for sale: Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Loans held for sale: The fair value of loans held for sale is determined using quoted secondary market prices and investor commitments. Loans held for sale are classified as Level 2 in the fair value hierarchy.

Collateral dependent impaired loans: Fair value of impaired loans with specific allocations of the allowance for loan losses is measured based on the value of the collateral securing these loans and is classified as Level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory and/or accounts receivable and collateral value is determined based on appraisals performed by qualified licensed appraisers hired by the Company. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(12.) FAIR VALUE MEASUREMENTS (Continued)

Loan servicing rights: Loan servicing rights do not trade in an active market with readily observable market data. As a result, the Company estimates the fair value of loan servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The assumptions used in the discounted cash flow model are those that we believe market participants would use in estimating future net servicing income, including estimates of loan prepayment rates, servicing costs, ancillary income, impound account balances, and discount rates. The significant unobservable inputs used in the fair value measurement of the Company’s loan servicing rights are the constant prepayment rates and weighted average discount rate. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the constant prepayment rate and the discount rate are not directly interrelated, they will generally move in opposite directions. Loan servicing rights are classified as Level 3 measurements due to the use of significant unobservable inputs, as well as significant management judgment and estimation.

Other real estate owned (Foreclosed assets): Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Off-balance sheet instruments: The fair value of off-balance-sheet instruments is based on the current fees that would be charged to enter into or terminate such arrangements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

Assets Measured at Fair Value

The following tables present for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and non-recurring basis as of the dates indicated (in thousands).

	Quoted Prices in Active Markets for Identical Assets or Liabilities		Significant Other Observable Inputs		Significant Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
June 30, 2013
Measured on a recurring basis:
Securities available for sale:
U.S. Government agencies and government sponsored enterprises	$	—	$	112,939	$	—	$	112,939
State and political subdivisions		—		222,706		—		222,706
Mortgage-backed securities		—		474,427		—		474,427
Asset-backed securities:
Trust preferred securities		—		207		—		207
Other		—		270		—		270
	$	—	$	810,549	$	—	$	810,549
Measured on a nonrecurring basis:
Loans:
Loans held for sale	$	—	$	3,423	$	—	$	3,423
Collateral dependent impaired loans		—		—		5,038		5,038
Other assets:
Loan servicing rights		—		—		1,729		1,729
Other real estate owned		—		—		415		415
	$	—	$	3,423	$	7,182	$	10,605

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(12.) FAIR VALUE MEASUREMENTS (Continued)

	Quoted Prices in Active Markets for Identical Assets or Liabilities		Significant Other Observable Inputs		Significant Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
December 31, 2012
Measured on a recurring basis:
Securities available for sale:
U.S. Government agencies and government sponsored enterprises	$	—	$	131,695	$	—	$	131,695
State and political subdivisions		—		195,210		—		195,210
Mortgage-backed securities		—		495,868		—		495,868
Asset-backed securities:
Trust preferred securities		—		754		—		754
Other		—		269		—		269
	$	—	$	823,796	$	—	$	823,796
Measured on a nonrecurring basis:
Loans:
Loans held for sale	$	—	$	1,518	$	—	$	1,518
Collateral dependent impaired loans		—		—		2,364		2,364
Other assets:
Loan servicing rights		—		—		1,719		1,719
Other real estate owned		—		—		184		184
	$	—	$	1,518	$	4,267	$	5,785